New revenue guidance Implementation in the pharmaceutical and life sciences sector

No. US2017-20 September 06, 2017 What s inside: Overview... 1 Scope... 2 Step 1: Identify the contract. 2 Step 2: Identify performance obligations.. 4 Step 3: Determine transaction price.7 Step 4: Allocate transaction price 14 Step 5: Recognize revenue 16 Licenses of intellectual property.. 21 Other considerations 30 New revenue guidance Implementation in the pharmaceutical and life sciences sector At a glance Public companies must adopt the new revenue standards in 2018. Almost all companies will be affected to some extent by the new guidance, though the effect will vary depending on industry and current accounting practices. Although originally issued as a converged standard, the FASB and IASB have made slightly different amendments, so the ultimate application of the guidance could differ under US GAAP and IFRS. The Revenue Recognition Transition Resource Group (TRG) has discussed various implementation issues impacting companies across many industries. These discussions may provide helpful insight into application of the guidance and the SEC expects registrants to consider these discussions in applying the new guidance. This publication reflects the implementation developments over the past few years and highlights certain challenges specific to companies in the pharmaceutical and life sciences industry. The content in this publication should be considered together with our global Revenue guide, available at CFOdirect.com. Overview The pharmaceutical and life sciences industry includes a number of sub-sectors, the largest being pharmaceuticals, biotechnology, contract research organizations, and medical devices. The common feature is that each sub-sector develops, produces, and markets a diverse array of products, technologies, and services that relate to human health. Revenue recognition issues arise not only from the sale of drugs and medical devices, but increasingly from arrangements between companies in the industry to develop and bring products to market. Companies in the pharmaceutical and life sciences industry often enter into arrangements to develop drugs, either as a supplier of services, a consumer of those services, or through execution of license arrangements. These complex transactions are accounted for under the revenue standards (ASC 606 and IFRS 15, Revenue from contracts with customers). This publication focuses on how the revenue standards will impact companies in the pharmaceutical and life sciences industry and contrasts the guidance with current practice under US GAAP and IFRS. The examples and related discussions are intended to provide areas of focus to assist companies in evaluating the implications of the revenue standards. National Professional Services Group CFOdirect Network www.cfodirect.pwc.com In depth 1

Scope While certain contracts are scoped out of the revenue standards (e.g., lease contracts, insurance contracts, financial instruments, guarantees excluding warranties, certain non-monetary exchanges), the revenue standards apply to just about all contracts with customers. A customer is defined as a party that has contracted with a company to obtain goods or services that are an output of the company s ordinary activities in exchange for consideration. The revenue standards do not apply to contracts when the parties participate in an activity or process (such as developing an asset in a collaboration agreement) and both parties share in the significant risks and benefits that result from the activity or process. One challenge for companies in the pharmaceutical and life sciences industry will be evaluating their collaboration arrangements to determine if they represent contracts with customers. A contract to develop a product with a collaborator or partner with shared risks and benefits may be outside the scope of the revenue standards because that type of arrangement is not for the sale of goods or services that are an output of the company s ordinary activities. For example, an agreement between a biotechnology company and pharmaceutical company to share equally in the significant risks and benefits associated with development of a specific drug is likely not in the scope of the revenue standards if the parties have a collaborative relationship rather than a vendor-customer relationship. If, however, the substance of the arrangement is that the biotechnology company is licensing its intellectual property (IP) or selling its compound to the pharmaceutical company and/or providing research and development (R&D) services, it will likely be in scope if such activities result in a good or service that is an output of the biotechnology company s ordinary activities. Determining whether an arrangement is in the scope of the revenue standards can be complex. Arrangements may contain elements of both a customer and collaborator relationship. When analyzing arrangements, companies should identify the activities of the parties, understand the risks and benefits resulting from the activities, and determine if the parties are sharing in those risks and benefits. It will also be important to determine which party receives goods or services and whether those goods or services represent an output of the ordinary activities of the delivering party. If such arrangements (or certain obligations in these arrangements) are outside the scope of the revenue standards, the related income might not meet the definition of revenue, but instead be recorded as other income or in some cases, contra-expense. For contracts that include some components that are in the scope of the revenue standards and other components that are in the scope of other standards, such as collaboration arrangements, a company will first apply the separation and/or measurement guidance in the other standards, if any. The transaction price will be reduced by the portion subject to the other standards and the revenue standards will apply to the remaining transaction price. For example, a company might lease a medical device to its customer and also provide related training services and consumables. In this arrangement, the lease would be subject to lease accounting while the training services and consumables may be subject to the revenue standards. (1) Identify the contract (2) Identify performance obligations (3) Determine transaction price (4) Allocate transaction price (5) Recognize revenue Licenses and other considerations 1. Identify the contract A contract can be written, oral, or implied by a company s customary business practices. Generally, any agreement with a customer that creates legally-enforceable rights and obligations meets the definition of a contract. Legal enforceability depends on the interpretation of the law and could vary across legal jurisdictions when the rights of the parties are not necessarily enforced in the same way. Companies in the pharmaceutical and life sciences industry should consider any history of entering into amendments or side agreements to a contract that either change the terms of, or add to, the rights and obligations of a contract. These can be verbal or written, and could include cancellation, termination, or other provisions. They could also provide customers with options or discounts or change the substance of the arrangement. All of these have implications for National Professional Services Group www.cfodirect.com In depth 2

revenue recognition. Therefore, understanding the entire contract, including any amendments, is important to the accounting conclusion. As part of identifying the contract, companies are required to assess whether collection of the consideration is probable, which is generally interpreted as a 75-80% likelihood in US GAAP and a greater than 50% likelihood in IFRS. This assessment is made after considering any price concessions expected to be provided to the customer. In other words, price concessions are variable consideration (which affects the transaction price), rather than a factor to consider in assessing collectibility. Further, the FASB clarified in an amendment of ASC 606 that companies should consider, as part of the collectibility assessment, their ability to mitigate their exposure to credit risk, for example, by ceasing to provide goods or services in the event of non-payment. The IASB did not amend IFRS 15 on this point, but did include additional discussion regarding credit risk in the Basis for Conclusions of their amendments to IFRS 15, which is likely to result in the same answer under both revenue standards. New standards Current US GAAP Current IFRS A company will account for a contract with a customer when: The parties have approved the contract; Each party s rights to goods or services to be transferred can be identified; The payment terms are defined; The contract has commercial substance; and It is probable the company will collect substantially all of the consideration. The assessment of whether an amount is probable of being collected is made after considering any price concessions expected to be provided to the customer. Management should first determine whether it expects the company to accept a lower amount of consideration from the customer than the customer is obligated to pay, then determine if the remaining amount is collectible. If management concludes that collection is not probable, the arrangement is not accounted for using the five-step model. In that case, the company will only recognize consideration received as revenue when one of the following events occurs: There are no remaining obligations to transfer goods or services to the customer and substantially all of the consideration has been received and is nonrefundable. The contract has been terminated, and the consideration received is A company is prohibited from recognizing revenue from an arrangement until persuasive evidence of it exists, even if the other revenue recognition criteria have been met. Evidence of the arrangement should be consistent with the vendor's customary business practices. If the vendor customarily obtains a written contract, a contract signed by both parties is the only acceptable evidence that the agreement exists. If the vendor does not customarily obtain a signed contract, the vendor must have other forms of evidence documenting that an arrangement exists (such as a purchase order, online authorization, and electronic communication or credit card authorization). Revenue from an arrangement is deferred in its entirety if a company cannot conclude that collection from the customer is reasonably assured. A company is required to consider the underlying substance and economics of an arrangement, not merely its legal form. A company must establish that it is probable that the economic benefits of the transaction will flow to the company before it can recognize revenue. National Professional Services Group www.cfodirect.com In depth 3

New standards Current US GAAP Current IFRS nonrefundable. The company transferred control of the goods or services, the company stopped transferring goods or services to the customer (if applicable) and has no obligation to transfer additional goods or services, and the consideration received from the customer is nonrefundable [US GAAP only]. Collectibility The collectibility threshold is not expected to significantly change current practice. A company will assess whether collection of the transaction price is probable under both US GAAP and IFRS, and, if it is, the company will recognize revenue as the performance obligations are satisfied, similar to today s practice. If, at contract inception, a company concludes that collectibility of the transaction price is not probable, then a contract does not yet exist. 1 Initial and subsequent impairment of customer receivables, to the extent material, will be presented separately below gross margin as an expense. This expense will be separately presented on the face of the income statement if it is material. Example 1-1 Assessing collectibility with a history of price concessions Facts: Pharma sells prescription drugs to a government entity for $5 million. Pharma has historically experienced long delays in payment for sales to this entity. Pharma has sold prescription drugs to this entity for the last five years and continues to sell prescription drugs at its normal market price. In the past, Pharma has ultimately been paid, but only after agreeing to significant price concessions. Based on historical experience, Pharma expects to issue a price concession of $3 million on this contract. How should Pharma account for the $5 million sale to the government entity? Analysis: Pharma will need to evaluate its contract with the government entity at the inception of the arrangement to determine if it is probable that it will collect the amounts to which it is entitled in exchange for the prescription drugs. The revenue standards indicate that for purposes of determining the transaction price, the company should consider the variable consideration guidance, including the possibility of price concessions. As a result of the expected price concession, the transaction price would be $2 million. Pharma would then evaluate whether it is probable it will collect the adjusted transaction price in order to determine whether there is a contract. Assuming the collectibility hurdle is met, the transaction price would be recognized as Pharma satisfies its performance obligation of delivering the drug. Pharma would also need to determine if there is a significant financing component embedded in the arrangement if the company expects to receive the transaction price on a delayed basis. (1) Identify the contract (2) Identify performance obligations (3) Determine transaction price (4) Allocate transaction price (5) Recognize revenue Licenses and other considerations 2. Identify performance obligations Many companies within the pharmaceutical and life sciences industry provide multiple products or services to their customers as part of a single arrangement. For example, medical device companies often transfer equipment with consumables and also perform installation, training, or other maintenance services. Contract research organizations offer a broad array of services that enable a customer to outsource parts or all of its clinical trial process. Companies 1 The revenue standards include examples illustrating collectibility assessments and evaluation of whether there is an implicit price concession resulting in the transaction price not being equal to the stated price. National Professional Services Group www.cfodirect.com In depth 4

must identify the separate performance obligations in an arrangement based on the terms of the contract and the company s customary business practices. A bundle of goods and services might be accounted for as a single performance obligation in certain fact patterns. New standards Current US GAAP Current IFRS A performance obligation is a promise in a contract to transfer to a customer either: A good or service (or a bundle of goods or services) that is distinct; or A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer. A good or service is distinct if both of the following criteria are met: The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (capable of being distinct). The good or service is separately identifiable from other goods or services in the contract (distinct in the context of the contract). Factors that indicate that two or more promises to transfer goods or services to a customer are not separately identifiable include (but are not limited to): a. The company provides a significant service of integrating the goods or services with other goods or services promised in the contract. b. One or more of the goods or services significantly modifies or customizes the other goods or services. c. The goods or services are highly interdependent or highly interrelated. ASC 606 states that a company is not required to separately account for promised goods or services that are immaterial in the context of the contract. IFRS 15 does not include the same specific guidance; however, IFRS reporters should consider materiality when identifying performance obligations. The following criteria are applied to transactions to determine if elements included in a multiple-element arrangement should be accounted for separately: The delivered item has value to the customer on a standalone basis. If a general return right exists for the delivered item, delivery or performance of the undelivered item(s) is considered probable and substantially in the control of the vendor. The revenue recognition criteria are usually applied separately to each transaction. In certain circumstances, it might be necessary to separate a transaction into identifiable components to reflect the substance of the transaction. Two or more transactions might need to be grouped together when they are linked in such a way that the commercial effect cannot be understood without reference to the series of transactions as a whole. National Professional Services Group www.cfodirect.com In depth 5

Assessing whether goods and services are capable of being distinct is similar to determining if deliverables have standalone value under existing US GAAP or are separate components under existing IFRS, although the definitions are not identical. Under the new guidance, management will assess if the customer can benefit from the good or service with resources that are readily available to the customer, which could be a good or service sold separately by the company or another company, or a good or service the customer has already obtained. Companies will need to determine whether the nature of the promise, within the context of the contract, is to transfer each of those goods or services individually or, instead, to transfer a combined item to which the promised goods or services are inputs. This will be a new assessment for companies as compared to today. Installation of equipment Medical device companies often provide installation services upon the placement of equipment at the customer s location. These installation services range from activities that are basic or routine in nature to activities that substantially customize or modify the placed equipment. The nature of the services impact the determination as to whether installation is a separate performance obligation from the equipment itself. There are generally two performance obligations in arrangements for which the placed equipment is operational without any customization or modification and the installation required is not complex. In these cases, the customer can benefit from the equipment on its own or with other readily available resources. The promises are separately identifiable because the equipment and installation services are not inputs into a combined item for which the customer has contracted. In other words, the vendor can fulfill its promise to transfer each promise independently and does not provide any significant integration, modification, or customization services. Conversely, there is generally one performance obligation if the equipment is not operational without installation services that customize or modify the equipment. In these instances, the equipment and installation services may be considered inputs into a combined item for which the customer has contracted. Promises within a contract should not be combined solely because one of the goods or services would not have been purchased without the others. For example, a contract that includes delivery of equipment and routine installation is not necessarily a single performance obligation even though the customer would not purchase the installation if it had not purchased the equipment. Similarly, contractual requirements to use a particular vendor s installation service does not impact the evaluation of whether the service is distinct from the equipment or other promises in an arrangement. Refer to the Licenses of intellectual property section for additional information and examples of distinct promises in licensing arrangements. Customer options that provide a material right An option that provides a customer with free or discounted goods or services in the future might be a material right. A material right is a promise embedded in the current contract that should be accounted for as a separate performance obligation. If the option provides a material right to the customer, the customer, in effect, pays the company in advance for future goods or services, and the company recognizes revenue when those future goods or services are transferred or when the option expires. An option to purchase additional goods or services at their standalone selling prices is a marketing offer and, therefore, not a material right. This is true regardless of whether the customer obtained the option only as a result of entering into the current transaction. An option to purchase additional goods or services in the future at a current standalone selling price could be a material right if prices are expected to increase. This is because the customer is being offered a discount on future goods or services compared to what others would have to pay as a result of entering into the current transaction. Example 2-1 Options for additional goods or services Facts: MedTech enters into an arrangement for the sale of surgical instruments to Hospital. In conjunction with the sale, MedTech provides Hospital an option to purchase consumables for use with the surgical instruments for a oneyear period at their standalone selling prices. Standalone selling price for the consumables is not expected to increase for the next two years. The consumables are needed to operate the surgical instrument, and MedTech is the only company that provides these consumables. In addition, MedTech offers to Hospital the option to purchase a different National Professional Services Group www.cfodirect.com In depth 6

surgical instrument at 40% off list price. Other comparable customers are typically provided a discount of 10% off list price. The option to purchase this instrument expires two years from executing this agreement. How should MedTech evaluate Hospital s option to purchase consumables and the additional surgical instrument? Analysis: At contract inception, MedTech should not account for the option to purchase consumables as a performance obligation as the option does not represent a material right (because the price offered to Hospital represents standalone selling price that is not expected to increase during the option term). The fact that the consumables are needed to operate the surgical instrument and MedTech is the only company that sells these consumables does not impact this assessment. In other words, unless the subsequent purchases are enforceable by law or represent a material right, they are not part of the initial contract regardless of the probability that the customer will make them. Therefore, MedTech would account for each of Hospital s purchases of consumables as a separate performance obligation if and when Hospital exercises the option to purchase these goods. The option to transfer the additional instrument at a significantly discounted price represents a material right to Hospital; therefore, this option should be accounted for as a separate performance obligation at contract inception. Because all comparable customers receive a 10% discount on the instrument during the same timeframe, the standalone selling price of the material right should be based on the incremental 30% discount offered to Hospital in the contract. MedTech should adjust the standalone selling price for the likelihood that Hospital will exercise the option (i.e., breakage ). The amount of the transaction price allocated to the material right would be recognized as revenue when the additional instrument is purchased or when the option expires (that is, after the two year period). Example 2-2 Free goods Facts: Pharma sells a drug in Country A subject to reimbursement through Country A s government healthcare system. A $50 million cap on reimbursed sales to public (government-managed) hospitals was established at the outset of sales in 2017 in negotiation with the government, which represents 50,000 expected unit sales at the agreed-upon unit price of $1,000. Upon exceeding this 50,000 unit cap, Pharma would be required to provide any incremental units for the remainder of the year at no charge (i.e., no reimbursement from the government). How should Pharma record unit sales during 2017 under the revenue standards? Analysis: The ability to receive incremental free units would constitute a material right. As a material right, Pharma would conclude that the contractual arrangement entered into with the government on behalf of eligible patients offers significant discounts on future purchases (in this case, free product for units above the 50,000 unit cap) that would not be available without having entered into the contractual arrangement with the government. At contract inception, Pharma must first estimate the amount of free units and then allocate and defer a portion of the transaction price to the free product. The deferred portion would be recognized as revenue whenever those additional units are transferred or when the material right expires, if unexercised. (1) Identify the contract (2) Identify performance obligations (3) Determine transaction price (4) Allocate transaction price (5) Recognize revenue Licenses and other considerations 3. Determine transaction price The transaction price is the consideration a vendor expects to be entitled to in exchange for satisfying its performance obligations in an arrangement. Determining the transaction price is straightforward when the contract price is fixed, but is more complex when the arrangement includes a variable amount of consideration. Variable consideration includes payments in the form of milestone payments, royalties, rebates, price protection, performance bonuses, and other discounts and incentives. Common examples of arrangements with variable consideration in the pharmaceutical and life sciences industry include licensing arrangements with development-based and/or sales-based milestone payments and sales-based royalties (discussed further below), and distribution arrangements with rebates, price protection, returns provisions, or other incentives provided to or available from wholesalers, retailers, and end customers. National Professional Services Group www.cfodirect.com In depth 7

If the promised amount of consideration in a contract is variable, a company should estimate the total transaction price. This estimate can be based on either the expected value (probability-weighted estimate) or the most likely amount of consideration expected from the transaction, whichever is more predictive. The estimated transaction price should be updated at each reporting date to reflect the current facts and circumstances. In general, with the exception of sales- or usage-based royalties in exchange for intellectual property (discussed further below), the estimate of variable consideration is subject to a constraint. The objective of the constraint is for a company to include in the transaction price some or all of an amount of variable consideration only to the extent that it is probable (US GAAP) or highly probable (IFRS) that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved. Such a reversal would occur if there is a significant downward adjustment of the cumulative amount of revenue recognized for a specific performance obligation. Companies will need to apply judgment to determine if variable consideration is subject to a significant reversal. The following indicators might suggest that variable consideration could result in a significant reversal of cumulative revenue recognized in the future: The amount of consideration is highly susceptible to factors outside the influence of the company. Those factors may include volatility in the market, the judgment or actions of third parties (e.g., regulatory approval of a drug compound), the successful outcome of a clinical trial, and a high risk of obsolescence of the promised good or service. Resolution of the uncertainty about the amount of consideration is not expected for a long period of time. The company has limited experience with similar types of contracts or that experience has limited predictive value. The company has a practice of either offering a broad range of price concessions or changing the payment terms and conditions of similar contracts in similar circumstances. The contract has a large number and broad range of possible consideration amounts. Companies will need to determine if there is a portion of the variable consideration (i.e., a minimum amount) that will not result in a significant revenue reversal. That amount will be included in the estimated transaction price. The estimate will be reassessed each reporting period, including any estimated minimum amounts. Consideration payable to a customer, right of return, noncash consideration, and significant financing components are other important concepts to consider in determining the transaction price. Rebates, price protection, and other discounts and incentives New standards Current US GAAP Current IFRS Rebates, price protection, concessions, and other discounts and incentives are types of variable consideration. Therefore, the consideration will be estimated and included in the transaction price based on either the expected value (probability-weighted estimate) or most likely amount approach if it is probable (US GAAP) or highly probable (IFRS) that a significant reversal of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved. The transaction price should include any minimum amount of variable consideration not subject to significant reversal, even if the entire The seller's price must be fixed or determinable for revenue to be recognized. Rebates, price protection clauses, and other discounts and incentives must be analyzed to conclude whether all of the revenue from the current transaction is fixed or determinable. Rebates or refunds are recognized on a systematic and rational basis. Measurement of the total rebate or refund obligation is based on the estimated number of purchases that the customer will ultimately make under the arrangement. If the rebate or incentive payment cannot be reasonably estimated, a liability is recognized for the maximum potential refund or rebate. Revenue is measured at the fair value of the consideration received or receivable. Fair value is the amount an asset could be exchanged for, or a liability settled, between knowledgeable, willing parties in an arm's length transaction. Trade discounts, volume rebates, and other incentives (such as cash settlement discounts or government claw-backs) are taken into account in measuring the fair value of the consideration to be received. Revenue related to variable consideration is recognized when it is probable that the economic benefits will flow to the company and the amount is reliably measurable, assuming all other revenue recognition criteria are met. National Professional Services Group www.cfodirect.com In depth 8

New standards Current US GAAP Current IFRS amount cannot be included in the transaction price due to the constraint. Companies in the pharmaceutical and life sciences industry likely already consider the impact of rebates, price protection, and other concessions on revenue recognition. Companies might see some changes to their accounting and processes related to rebates or concessions as estimates are required to be made upfront when determining the transaction price. Other changes include those situations when companies did not recognize revenue because the price was not fixed or determinable. Under the revenue standards, these companies might recognize revenue earlier if there is a minimum amount of variable consideration that is not subject to significant reversal in the future. Example 3-1 Estimating rebates to a customer Facts: MedTech enters into an arrangement to sell a product to a customer. At the end of each year, the customer is entitled to a rebate on its annual purchases whereby the price per unit is retrospectively reduced based on achievement of specific purchasing levels. MedTech has determined based on its experience with similar contracts that it is probable (US GAAP) or highly probable (IFRS) that including an estimate of variable consideration will not result in a significant reversal of cumulative revenue recognized in the future. The estimated amount of the rebate is determined based on the number of units purchased during the year as follows: Units purchased Per unit Expected rebate probability 0 100,000 10% 80% 100,000 500,000 15% 15% 500,000+ 20% 5% How should MedTech account for the potential rebate to the customer? Analysis: Since the rebate has retrospective implications on the per unit price, the consideration in the contract is considered variable at contract inception. MedTech should estimate the amount of the rebate using an expected value (probability-weighted estimate) or most likely outcome approach, whichever is more predictive. A probability-weighted estimate would result in a rebate of approximately 11% ((10% x 80%) + (15% x 15%) + (20% x 5%)). The most-likely outcome approach would result in an estimated rebate of 10%. If MedTech is unsure whether the estimated amount will result in a significant reversal of revenue, the company should only include in the transaction price an amount that is probable (US GAAP) or highly probable (IFRS) of not resulting in a significant reversal of cumulative revenue recognized (i.e., a minimum amount). Example 3-2 Retroactive payback provisions Facts: Companies that operate in the medical device industry in Country A are required to make payments to Country A s government health system equal to a stated percentage of domestic industry sales that exceed regional maximum ceilings (caps) in a given year. If triggered, the portion of the payback provision allocable to a particular company is based on that company s current market share relative to the medical device industry as a whole. The industry-wide payback amount in 2017 may not exceed 50% of sales in excess of the regional maximum ceiling. A regional maximum ceiling of $500 million was implemented for all medical device sales in Country A during 2017. MedTech expects to sell $200 million of medical devices in Country A during 2017 and, based on historical industry performance and other available data, expects that total industry sales of medical devices will approximate $800 million for the year. Therefore, MedTech s obligation is estimated to be $37.5 million for the year, which is calculated as MedTech s 25% estimated market share ($200 million/$800 million) multiplied by the excess industry sales subject to the payback provision (50% x ($800 million - $500 million)). How should MedTech record unit sales in 2017? Analysis: The amount due under the payback provision would be accounted for as a retroactive rebate (i.e., variable consideration). National Professional Services Group www.cfodirect.com In depth 9

MedTech would estimate its portion of the payback at the beginning of the year, likely using the expected value approach due to the range of possible outcomes in this fact pattern. MedTech would include the variable consideration in the transaction price to the extent it is probable (US GAAP) or highly probable (IFRS) that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty is resolved. If MedTech concluded that it could not estimate the variable consideration to identify a minimum amount, it would constrain the full amount of the potential payment (i.e., 50% of each sale made in 2017) until it is able to estimate such an amount. Assuming the variable consideration constraint could be overcome, MedTech would reflect each sale during 2017 at a discount of 18.75%, such that by the end of the year, it would have accrued a refund liability to the government health system of $37.5 million. Medicare Part D coverage gap The Medicare Part D Coverage Gap ( coverage gap or donut hole ) is a government program under the Patient Protection and Affordable Care Act (PPACA) in which all pharmaceutical drug manufacturers are responsible for paying 50% of the cost of their branded drugs when a patient falls within the coverage gap during a calendar year. While in the coverage gap, a patient temporarily loses Medicare Part D insurance coverage on prescription drugs based on annual drug costs incurred by that patient and, therefore, must pay for a portion of the drugs out-of-pocket. Under the PPACA, while patients are in the coverage gap, pharmaceutical manufacturers are required to provide discounted products to eligible Medicare beneficiaries receiving covered Part D drugs to alleviate the out-of-pocket cost burden on the patient. Under existing practice, companies make a policy election between two acceptable methods a spreading approach or a point-of-sale approach (sometimes referred to as a specific identification approach). Under the spreading method, the estimated impact of the rebate expected to be incurred for the annual period is recognized ratably using an estimated, effective rebate rate for all of a company s projected sales to Medicare patients throughout the year. Under the point-of-sale method, the rebate is recognized at the time a company recognizes revenue on sales of drugs into the channel that are expected to be resold to Medicare patients who are in the coverage gap. The point-of-sale method is premised on the fact that the Federal government is not the customer and that each individual sale to an end customer stands on its own. Under the new guidance, we believe those same two approaches will generally continue to be supportable noting the following: The revenue standards introduce the concept of a material right (see prior discussion in Step 2). The spreading method appears to be broadly consistent with the accounting for an option (i.e., a material right) provided to a customer. Under this method, companies will allocate a portion of the transaction price between current sales and the material right, which represents the discount to be provided on future sales to any Medicare-eligible patient within the coverage gap, and recognize the value of the material right into revenue when the coverage gap subsidies are utilized. However, we are aware that in some cases, companies experience higher coverage gap liabilities earlier in the year (e.g., with certain more expensive drugs) with sales reverting back to list price in subsequent periods. In these cases, it would not be appropriate to follow a spreading approach that results in a contract asset on the balance sheet as that would, in effect, be inappropriately pulling revenue forward for optional purchases. Whichever method is applied would need to be applied on a consistent basis for similar arrangements. Example 3-3 Medicare Part D coverage gap Facts: Pharma currently has one marketed product that is impacted by the Medicare coverage gap provision. Gross revenue of $500 million is earned every quarter. Pharma s full year estimate of coverage gap subsidies (i.e., reimbursements to the Federal government) is $400 million. Pharma s inventory does not sit in the channel at the end of a particular quarter (i.e., product sold in Q2 will be sold through to the end customer in Q2). Pharma s customers primarily enter and exit the Medicare coverage gap in the third and fourth quarters. Pharma s quarterly revenues, net of coverage gap subsidies, are as follows: In millions Q1 Q2 Q3 Q4 Total Actual sales per quarter, net of $500 $500 $250 $350 $1,600 subsidies Spread basis $400 $400 $400 $400 $1,600 Quarterly difference $100 $100 ($150) ($50) - Cumulative year-to-date difference $100 $200 $50 $0 - National Professional Services Group www.cfodirect.com In depth 10

How should Pharma account for its coverage gap obligations? Analysis: If Pharma accounts for coverage gap subsidies as a material right, it would recognize a contract liability for $100, $200, and $50 at the end of Q1, Q2, and Q3, respectively. The contract liability, reflecting the material right in the arrangement (i.e., the discounted future product available from cumulative list price purchases to date), would fully reverse in Q4. The contract liability would be calculated in accordance with the practical alternative provided in the revenue standards, which provides an election to include the total number of estimated drugs to be sold during the year in the initial measurement of the transaction price of each drug. In other words, all sales of drugs before, during, and after the incurrence of coverage gap liabilities would be priced at a discount to reflect the reduced transaction price for drugs sold during the period in which Pharma is liable to fund a portion of patient costs through this program. If Pharma accounts for coverage gap subsidies using a specific identification approach, it would recognize the subsidies as a reduction of revenue in the periods they are incurred. Therefore, Pharma would record no reduction in revenue in either Q1 or Q2 and would instead reflect a reduction of revenue of $250 and $150 in Q3 and Q4, respectively. Consideration payable to a customer A company might pay, or expect to pay, consideration to its customer. The consideration paid can be cash, either in the form of rebates or upfront payments, or a credit or other incentive that reduces amounts owed to the company by a customer. Payments to customers can also be in the form of equity. Management should consider whether payments to customers are related to a revenue contract even if the timing of the payment is not concurrent with a revenue transaction. Such payments could nonetheless be economically linked to a revenue contract; for example, the payment could represent a modification to the transaction price in a contract with a customer. Management will therefore need to apply judgment to identify payments to customers that are economically linked to a revenue contract. An important step in this analysis is identifying the customer in the arrangement. Management will need to account for payments made directly to its customer, payments to another party that purchases the company s goods or services from its customer (that is, a customer s customer within the distribution chain), and payments to another party made on behalf of a customer pursuant to the arrangement between the company and its customer. Consideration payable to a customer is recorded as a reduction of the arrangement s transaction price, thereby reducing the amount of revenue recognized, unless the payment is for a distinct good or service received from the customer. If payment is for a distinct good or service, it would be accounted for in the same way the company accounts for other purchases from suppliers. Determining whether a payment is for a distinct good or service received from a customer requires judgment. A company might be paying a customer for a distinct good or service if the company is purchasing something from the customer that is normally sold by that customer. Management also needs to assess whether the consideration it pays for distinct goods or services from its customer exceeds the fair value of those goods or services. Consideration paid in excess of fair value reduces the transaction price. It can be difficult to determine the fair value of the distinct goods or services received from the customer in some situations. A company that is not able to determine the fair value of the goods or services received should account for all of the consideration paid or payable to the customer as a reduction of the transaction price since it is unable to determine the portion of the payment that is a discount provided to the customer. Example 3-4 Estimating rebates to indirect customers Facts: Pharma enters into an arrangement with Distributor for the sale of a drug. Distributor then sells the product to Retailer. Retailer is entitled to a sales rebate from Pharma of 25% of the sales price if Retailer purchases at least 1,000 units from Distributor in bulk (that is, in one transaction). The unit selling price for each product is $100. Pharma believes that it has sufficient basis to estimate that Retailer will purchase the necessary 1,000 units to earn the rebate (i.e., Pharma has history and experience with the retail distribution channel and the buying patterns of Retailer with Distributor). Therefore, Pharma concludes that it is probable (US GAAP) or highly probable (IFRS) that a significant reversal in the amount of cumulative revenue recognized will not occur in the future. How should Pharma account for rebates to be paid to the indirect customer? National Professional Services Group www.cfodirect.com In depth 11

Analysis: The performance obligation in the contract is the promise to deliver individual units of the drug to Distributor. To determine the transaction price, Pharma will need to estimate the effects of the bulk rebates offered to Retailer. That is, each time a shipment is ordered by Distributor, Pharma will need to estimate what portion of the shipment will be sold on to Retailer, who will buy in bulk and earn the rebate. The total estimated rebate would be a reduction from the contractual sales price in the transactions with Distributor. Even though the product was sold to Distributor and the rebates are paid to Retailer, the classification of the payment is still a reduction of revenue on the basis that payments made by a company to its customer s customer are assessed and accounted for the same as those paid directly to the company s customer. Example 3-5 Discounts provided to group purchasing organizations Facts: MedTech sells disposable medical products to hospitals through a network of distributors at list price. The company has agreements in place with various group purchasing organizations (GPOs) to give a discount of 20% to specific hospitals affiliated with these GPOs. When a GPO-affiliated hospital purchases the disposable medical products from a distributor, it purchases them at the discounted amount. The distributor then requests reimbursement by MedTech of the discounted amount. The company has some historical data related to the mix of sales to GPOs and non- GPOs; however, the range varies significantly from period to period. How should MedTech account for GPO discounts? Analysis: MedTech would estimate variable consideration, including the estimated discount to be paid on sales to GPOaffiliated hospitals. The amount of revenue recognized would be the amount that is probable (US GAAP) or highly probable (IFRS) of not resulting in a significant reversal of cumulative revenue in the future. Although the company s history varies significantly, that history may indicate there is a minimum amount of revenue that can be recognized upon shipment of the product. Other considerations: Companies will often pay administrative fees to GPOs (and not directly to the GPO member) to cover operating expenses or other services for its members. A question exists as to whether these administrative fees paid to the GPOs are classified as a reduction of revenue or as an operating expense. In determining the accounting for the administrative fee paid to GPOs under the revenue standards, it is important to consider the relationships between the vendor, the GPO, and the GPO member in order to determine whether the GPO is a customer. Identifying the customer requires an evaluation of the substance of the relationship of all parties involved in the transaction. The following factors, if present, may indicate that the GPO is effectively an extension of the customer (that is, the GPO member) and, therefore, the GPO administrative fee should be recorded as a reduction of revenue: The GPO member is an owner, or partial owner, of the GPO; or There is a mechanism to flow through the administrative fee from the GPO to the GPO member. Noncash consideration Any noncash consideration received from a customer needs to be included in the transaction price and measured at fair value. The measurement date, however, may differ under US GAAP and IFRS. ASC 606 specifies that the measurement date for noncash consideration is contract inception, which is the date at which the criteria in Step 1 of the revenue model are met. Changes in the fair value of noncash consideration after contract inception are excluded from revenue. IFRS 15 does not include specific guidance on the measurement date of noncash consideration and therefore, different approaches may be acceptable. Management should also consider the accounting guidance for derivative instruments to determine whether an arrangement with a right to noncash consideration contains an embedded derivative. Significant financing component Pharmaceutical and life sciences companies should also be aware of the accounting impact of significant financing components, such as extended payment terms. If there is a difference between the timing of receiving consideration from the customer and the timing of the company s performance, a significant financing component may exist in the arrangement. The revenue standards require companies to impute interest income or expense and recognize it separately from revenue (as interest expense or interest income) when an arrangement includes a significant financing component. However, as a practical expedient, companies do not need to account for a significant financing component if the timing National Professional Services Group www.cfodirect.com In depth 12